Before the Great Recession, when profits were soaring, banks grew faster than their customers and the economy. Lending was excessive. Despite the unsustainability, lenders were generally heedless. In the aftermath, and with the world overleveraged, banks are struggling to adjust and reinvent themselves. Selling too hard has always been the industry's curse, inviting unnecessary and uneconomic borrowing and unsound credit practice.
Banks are up against contrary pressures. Despite slimming profit margins, new regulations and the erosion of their business by nonbanks, they need to be profitable enough to attract capital in support of economic growth. With little room to maneuver, the extension and control of credit must be near-perfect. Aggravating this, retirements, cost-cutting, staff reductions from mergers and the proliferation into new activities with new risks have diluted talent at every level.
The likely answer is a culture set by directors based on realistic credit policy commensurate with resources and professional competence. Policy is culture's mainspring and guardian and bears directly on the bank's liquidity, since money put out is unavailable until repaid. The starting point is to know banks' proper lending turf.
Everyone now realizes the world will never return to where it was. This redefines bank directors' responsibilities and qualifications. It means they are expected to think strategically and be alert to what is happening around them, as well as within their own banks. For example:
- Are board members sufficiently conversant about banking to challenge management's assumptions?
- Do the directors understand the risks the bank is taking?
- What are the banks' strengths, weaknesses, opportunities and threats?
- What are the portfolio's overall risks, concentrations and trends?
- Does the bank have geographic diversification?
- Are computer models based on valid assumptions?
- Developments often move ahead of the market's ability to reflect on risk. They may stem from unintended consequences or other forms of financial distortion. Previously well-defined rules of the business fail when markets are seriously out of balance because critical relationships between factors in the market differ from before and are not understood. Does the board have a committee that periodically delves into overall bank risk and unexpected happenings which could upend financial systems and cause the bank to lose control? What might these be and how likely are they to occur?
- Off-balance-sheet obligations sometimes have a way of coming home to roost. Where are they?
- What balls are being dropped in banking and why?
- Why are banks failing?
- What effect on the bank will new competition have and what makes it tick?
- How well do lending officers know and understand borrowers?
- What about the shortage of bank and director talent? How will the bank plan and cope with succession?
- Do the bank's computers fit its real needs? Are they economic, and what ability do the suppliers have to provide new technology when it is introduced?
Policy, process and audit dominate culture. While a bank's credit apparatus may be decentralized, credit policy is centralized because each bank needs a credit conscience. Process includes the delegation of lending authority and is based on an unambiguous administrative structure with checks and balances. It is the arm of risk-taking strategy, beginning with environmental scans leading to market strategies, business plans, business administration and repayment of principal. While policy must be part of the process when strategies are being developed, it is too late if credit policy is relegated to merely loan review. An audit is a comprehensive review mechanism used to evaluate performance and loan quality. It examines conformance with policy, practice and procedures, market threats, adherence to target markets, business plans, training gaps, administration and repayment.
After the board and CEO have agreed upon policy, portfolio parameters, standards and acceptance criteria, the CEO sets the bank's lending tone, whether or not he delegates his authority. A clearly defined and closely monitored culture, openly and strongly supported by the CEO and a well-informed board, are needed to sustain the integrity, consistency and stability of credit practice. The behavior of the bank's lending cadre reflects the CEO's attitudes, and what he says or doesn't say.
No bank can successfully control lending policy unless the CEO undertakes this duty or designates a senior credit officer to exercise the extension of his own conservative policy. During and prior to my own tenure at Citibank from 1974 to 1982, the chairman of credit policy was admonished by the CEO to act independently of him or other lending officers. No front office loans were made, and the CEO wasn't involved in credit extension. If contentions over policy exceptions arose, there were reasonable ways to resolve them so the weak credits didn't slip through and the strong ones were not misunderstood. Players should never be referees, and behind-the-scenes influence never tolerated.
Underlying a bank's culture is a layer of linked attitudes, responses and behavioral patterns emanating from the CEO, senior management, from those who immediately supervise credit officers and from the lending officers themselves. They relate to transactional consideration, education, personality, training, habit, age and banking experience, biases and the cultural confusion stemming from mergers.
The lending officer's job is to think responsibly and broadly and to see that unnecessary risks are avoided. He is expected to accurately identity and measure risk, then to protect against and manage it. Lenders must be convinced a loan will be collectible in the borrower's darkest hours. Gut issues should be addressed. Forecasts more often underestimate the downside than underestimate the upside. Too often credit training is focused on the analysis of numbers rather than on the situation and its risks. Lending is holistic. Lenders must always realize that their decisions can have unintended consequences.
Banking is a knowledge business and the learning experience in credit extension lasts throughout one's career. As in all professions, top performers are usually modest and know more. They synthesize varied data and quickly engage the elements needed to view and interpret problems in their entirety.
Absent discipline and accountability, banks can stumble because of such things as unrealistic incentives, poor execution, incompetence, excess and insensitivity to systemic risk. Common sense is of basic importance and intelligence should not trump wisdom. Successful marketing isn't necessarily sound risk-taking. When they are out of balance, earnings vaporize.
There are two books about culture published by the Risk Management Association worth the attention of bankers and bank directors: "
For institutional consistency and to enable lending officers to speak a common credit language, policy, time-tested lending guidelines and what the bank expects of its credit officers should be spelled out in a concise, user-friendly desk book. "Credit Doctrine for Lending Officers" illustrates this. In the spirit of disclosure, I wrote it in 1976.
The times are unsettling, unpredictable and unusual. Banks are outgrowing just the regulators' checklists. Regulators need focus. Banks' cultures are overdue for overhaul. The problem of deciding who will repay and who will not has been around for centuries. And so have the answers. History's lesson is that too many bankers have been disrespecting history. We reap what we sow. In short: easy credit, uneasy creditors.
P. Henry Mueller was the chief lending officer and chairman of the credit policy committee at Citicorp and Citibank from 1974 to 1982. His 1979 book "
